Historical development of central bank

A central bank is the term used to describe the authority responsible for policies that affect a
country’s supply of money and credit. More specifically, a central bank uses its tools of
monetary policy—open market operations, discount window lending, changes in reserve
requirements—to affect short-term interest rates and the monetary base (currency held by the
public plus bank reserves) and to achieve important policy goals.

Topics
Monetary policy
12.01.2007EC 12/1/2007

One of the world’s foremost economic historians explains the forces behind the development of
modern central banks, providing insight into their role in the financial system and the economy.

A central bank is the term used to describe the authority responsible for policies that affect a
country’s supply of money and credit. More specifically, a central bank uses its tools of
monetary policy—open market operations, discount window lending, changes in reserve
requirements—to affect short-term interest rates and the monetary base (currency held by the
public plus bank reserves) and to achieve important policy goals.

There are three key goals of modern monetary policy. The first and most important is price
stability or stability in the value of money. Today this means maintaining a sustained low rate of
inflation. The second goal is a stable real economy, often interpreted as high employment and
high and sustainable economic growth. Another way to put it is to say that monetary policy is
expected to smooth the business cycle and offset shocks to the economy. The third goal is
financial stability. This encompasses an efficient and smoothly running payments system and the
prevention of financial crises.

Beginnings
The story of central banking goes back at least to the seventeenth century, to the founding of the
first institution recognized as a central bank, the Swedish Riksbank. Established in 1668 as a
joint stock bank, it was chartered to lend the government funds and to act as a clearing house for
commerce. A few decades later (1694), the most famous central bank of the era, the Bank of
England, was founded also as a joint stock company to purchase government debt. Other central
banks were set up later in Europe for similar purposes, though some were established to deal
with monetary disarray. For example, the Banque de France was established by Napoleon in
1800 to stabilize the currency after the hyperinflation of paper money during the French
Revolution, as well as to aid in government finance. Early central banks issued private notes
which served as currency, and they often had a monopoly over such note issue.

While these early central banks helped fund the government’s debt, they were also private
entities that engaged in banking activities. Because they held the deposits of other banks, they
came to serve as banks for bankers, facilitating transactions between banks or providing other
banking services. They became the repository for most banks in the banking system because of
their large reserves and extensive networks of correspondent banks. These factors allowed them
to become the lender of last resort in the face of a financial crisis. In other words, they became
willing to provide emergency cash to their correspondents in times of financial distress.

Transition

The Federal Reserve System belongs to a later wave of central banks, which emerged at the turn
of the twentieth century. These banks were created primarily to consolidate the various
instruments that people were using for currency and to provide financial stability. Many also
were created to manage the gold standard, to which most countries adhered.

The gold standard, which prevailed until 1914, meant that each country defined its currency in
terms of a fixed weight of gold. Central banks held large gold reserves to ensure that their notes
could be converted into gold, as was required by their charters. When their reserves declined
because of a balance of payments deficit or adverse domestic circumstances, they would raise
their discount rates (the interest rates at which they would lend money to the other banks). Doing
so would raise interest rates more generally, which in turn attracted foreign investment, thereby
bringing more gold into the country.

Central banks adhered to the gold standard’s rule of maintaining gold convertibility above all
other considerations. Gold convertibility served as the economy’s nominal anchor. That is, the
amount of money banks could supply was constrained by the value of the gold they held in
reserve, and this in turn determined the prevailing price level. And because the price level was
tied to a known commodity whose long-run value was determined by market forces, expectations
about the future price level were tied to it as well. In a sense, early central banks were strongly
committed to price stability. They did not worry too much about one of the modern goals of
central banking—the stability of the real economy—because they were constrained by their
obligation to adhere to the gold standard.

Central banks of this era also learned to act as lenders of last resort in times of financial stress—
when events like bad harvests, defaults by railroads, or wars precipitated a scramble for liquidity
(in which depositors ran to their banks and tried to convert their deposits into cash). The lesson
began early in the nineteenth century as a consequence of the Bank of England’s routine
response to such panics. At the time, the Bank (and other European central banks) would often
protect their own gold reserves first, turning away their correspondents in need. Doing so
precipitated major panics in 1825, 1837, 1847, and 1857, and led to severe criticism of the Bank.
In response, the Bank adopted the “responsibility doctrine,” proposed by the economic writer
Walter Bagehot, which required the Bank to subsume its private interest to the public interest of
the banking system as a whole. The Bank began to follow Bagehot’s rule, which was to lend
freely on the basis of any sound collateral offered—but at a penalty rate (that is, above market
rates) to prevent moral hazard. The bank learned its lesson well. No financial crises occurred in
England for nearly 150 years after 1866. It wasn’t until August 2007 that the country
experienced its next crisis.

The U.S. experience was most interesting. It had two central banks in the early nineteenth
century, the Bank of the United States (1791–1811) and a second Bank of the United States
(1816–1836). Both were set up on the model of the Bank of England, but unlike the British,
Americans bore a deep-seated distrust of any concentration of financial power in general, and of
central banks in particular, so that in each case, the charters were not renewed.

There followed an 80-year period characterized by considerable financial instability. Between

1836 and the onset of the Civil War—a period known as the Free Banking Era—states allowed
virtual free entry into banking with minimal regulation. Throughout the period, banks failed
frequently, and several banking panics occurred. The payments system was notoriously
inefficient, with thousands of dissimilar-looking state bank notes and counterfeits in circulation.
In response, the government created the national banking system during the Civil War. While the
system improved the efficiency of the payments system by providing a uniform currency based
on national bank notes, it still provided no lender of last resort, and the era was rife with severe
banking panics.

The crisis of 1907 was the straw that broke the camel’s back. It led to the creation of the Federal
Reserve in 1913, which was given the mandate of providing a uniform and elastic currency (that
is, one which would accommodate the seasonal, cyclical, and secular movements in the
economy) and to serve as a lender of last resort.

The Genesis of Modern Central Banking Goals

Before 1914, central banks didn’t attach great weight to the goal of maintaining the domestic
economy’s stability. This changed after World War I, when they began to be concerned about
employment, real activity, and the price level. The shift reflected a change in the political
economy of many countries—suffrage was expanding, labor movements were rising, and
restrictions on migration were being set. In the 1920s, the Fed began focusing on both external
stability (which meant keeping an eye on gold reserves, because the U.S. was still on the gold
standard) and internal stability (which meant keeping an eye on prices, output, and employment).
But as long as the gold standard prevailed, external goals dominated.

Unfortunately, the Fed’s monetary policy led to serious problems in the 1920s and 1930s. When
it came to managing the nation’s quantity of money, the Fed followed a principle called the real
bills doctrine. The doctrine argued that the quantity of money needed in the economy would
 naturally be supplied so long as Reserve Banks lent funds only when banks presented eligible
self-liquidating commercial paper for collateral. One corollary of the real bills doctrine was that
the Fed should not permit bank lending to finance stock market speculation, which explains why
it followed a tight policy in 1928 to offset the Wall Street boom.

Development of banking in Ethiopia

The agreement that was reached in 1905 between Emperor Minilik II and Mr.Ma Gillivray,
representative of the British owned National Bank of Egypt marked the introduction of modern
banking in Ethiopia. Following the agreement, the first bank called Bank of Abysinia was
inaugurated in Feb.16, 1906 by the Emperor. The Bank was totally managed by the Egyptian
National Bank and the following rights and concessions were agreed upon the establishment of
Bank of Abyssinia:-

 The capital of the Bank was agreed to be Pound Sterling 500,000 and one-fifth was subscribed
and the rest was to be obtained by selling shares in some important cities such as London, Paris
and New York.

 The Bank was given full rights to issue bank notes and monitor coins which were to be legal
tender and all the profits there from a ruing to the bank and freely exchangeable against gold
and silver on cover by the Bank as well as to establish silver coins and abolish the Maria
Theresa.

 Land was given to the Bank free of charges & permitted to build offices and warehouses.
Government and public funds were to be deposited with the bank and all payments to be made
by checks.

 The government promised not to allow any bank to be established in the country within the 50-
year concession period.

Within the first fifteen years of its operation, Bank of Abyssinia opened branches in different
areas of the country. In 1906 a branch in Harar (Eastern Ethiopia) was opened at the same time
of the inauguration of Bank of Abyssinia in Addis Ababa. Another at Dire Dawa was opened two
years later and at Gore in 1912 and at Dessie and Djibouti in 1920. Mac Gillivray, the then
representative and negotiator of Bank of Egypt, was appointed to be the governor of the new
bank and he was succeeded by H Goldie, Miles Backhouse, and CS Collier were in change from
1919 until the Bank’s liquidation in 1931.

The society at that time being new for the banking service, Bank of Abyssinia had faced
difficulty of familiarizing the public with it. It had also need to meet considerable cost of
installation and the costly journeys by its administrative personnel. As a result, despite its
monopolistic position, the Bank earned no profit until 1914. Profits were recorded in 1919, 1920
and from 1924 onwards.

Generally, in its short period of existence, Bank of Abyssinia had been carrying out limited
business such as keeping government accounts, some export financing and undertaking various
tasks for the government. Moreover, the Bank faced enormous pressure for being inefficient and
purely profit motivated and reached an agreement to abandon its operation and be liquidated in
order to disengage banking from foreign control and to make the institution responsible to
Ethiopia’s credit needs. Thus by 1931 Bank of Abyssinia was legally replaced by Bank of
Ethiopia shortly after Emperor Haile Selassie came to power.

The new Bank, Bank of Ethiopia, was a purely Ethiopian institution and was the first indigenous
bank in Africa and established by an official decree on August 29, 1931 with capital of
£750,000. Bank of Egypt was willing to abandon its on cessionary rights in return for a payment
of Pound Sterling 40,000 and the transfer of ownership took place very smoothly and the offices
and personnel of the Bank Of Abyssinia including its manager, Mr. Collier, being retained by the
new Bank. Ethiopian government owned 60 percent of the total shares of the Bank and all
transactions were subject to scrutiny by its Minister of Finance.

Bank of Ethiopia took over the commercial activities of the Bank of Abysinia and was
authorized to issue notes and coins. The Bank with branches in Dire Dawa, Gore, Dessie, Debre
Tabor, Harar, agency in Gambella and a transit office in Djibouti continued successfully until the
Italian invasion in 1935. During the invasion, the Italians established branches of their main
Banks namely Banca d’Italia, Banco di Roma, Banco di Napoli and Banca Nazionale del lavoro
and started operation in the main towns of Ethiopia. However, they all ceased operation soon
after liberation except Banco di Roma and Banco di Napoli which remained in Asmara. In 1941
another foreign bank, Barclays Bank, came to Ethiopia with the British troops and organized
banking services in Addis Ababa, until its withdrawal in 1943. Then on 15th April 1943, the
State Bank of Ethiopia commenced full operation after 8 months of preparatory activities. It
acted as the central Bank of Ethiopia and had a power to issue bank notes and coins as the agent
of the Ministry of Finance. In 1945 and 1949 the Bank was granted the sole right of issuing
currency and deal in foreign currency. The Bank also functioned as the principal commercial
bank in the country and engaged in all commercial banking activities.

The State Bank of Ethiopia had established 21 branches including a branch in Khartoum, Sudan
and a transit office on Djibouti until it eased to exist by bank proclamation issued on December,
1963. Then the Ethiopian Monetary and Banking law that came into force in 1963 separated the
function of commercial and central banking creating National Bank of Ethiopia and commercial
Bank of Ethiopia. Moreover it allowed foreign banks to operate in Ethiopia limiting their
maximum ownership to be 49 percent while the remaining balance should be owned by
Ethiopians.

The National Bank of Ethiopia with more power and duties started its operation in January 1964.
Following the incorporation as a share company on December 16, 1963 as per proclamation
No.207/1955 of October 1963, Commercial Bank of Ethiopia took over the commercial banking
activities of the former State Bank of Ethiopia. It started operation on January 1,1964 with a
capital of Eth. Birr 20 million. In the new Commercial Bank of Ethiopia, in contrast with the
former State Bank of Ethiopia, all employees were Ethiopians.

There were two other banks in operation namely Banco di Roma S. . and Bank o di Napoli S.C.
that later reapplied for license according to the new proclamation each having a paidup capital of
Eth. Birr 2 million.

The first privately owned bank, Addis Ababa Bank share company, was established on
Ethiopians initiative and started operation in 1964 with a capital of 2 million in association with
National and Grindlay Bank, London which had 40 percent of the total share. In 1968, the
original capital of the Bank rose to 5.0 million and until it ceased operation, it had 300 staff at 26
branches.

There were other financial institutions operating in the country like the Imperial Savings and
Home Ownership public Association (ISHOPA) which specialized in providing loans for the
construction of residential houses and to individuals under the guarantee of their savings. There
was also the Saving and Mortgage Corporation of Ethiopia whose aims and duties were to accept
savings and trust deposits account and provide loans for the construction, repair and
improvement of residential houses, commercial and industrial buildings and carry out all
activities related to mortgage operations. On the other hand, there was a bank called Agricultural
Bank that provides loan for the agricultural and other relevant projects established in 1945. But
in 1951 the Investment Bank of Ethiopia replaced it. In 1965, the name of the bank once again
hanged to Ethiopian Investment Corporation Share Company and the capital raised to Eth. Birr
20 million, which was fully paid up. However, proclamation No.55 of 1970 established the
Agricultural and Industrial Development Bank Share Company by taking over the asset and
liability of the former Development Bank and Investment Corporation of Ethiopia.

Following the declaration of socialism in 1974 the government extended its control over the
whole economy and nationalized all large corporations. Organizational setups were taken in
order to create stronger institutions by merging those that perform similar functions.
Accordingly, the three private owned banks, Addis Ababa Bank, Banco di Roma and Banco di
Napoli Merged in 1976 to form the second largest Bank in Ethiopia called Addis Bank with a
capital of Eth. birr 20 million and had a staff of 480 and 34 branches. Before the merger, the
foreign participation of these banks was first nationalized in early 1975. Then Addis Bank and
Commercial Bank of Ethiopia S.C . were merged by proclamation No.184 of August 2, 1980 to
form the sole commercial bank in the country till the establishment of private commercial banks
in 1994. The Commercial Bank of Ethiopia commenced its operation with a capital of Birr 65
million, 128 branches and 3,633 employees. The Savings and Mortgage Corporation S. . and
Imperial Saving and Home Ownership Public Association were also merged to form the Housing
and Saving Bank with working capital of Birr 6.0 million and all rights, privileges, assets and
liabilities were transferred by proclamation No.60, 1975 to the new bank.Proclamation No.99 of
 1976 brought into existence the Agricultural and Industrial Bank, which was formed in 1970 as a
100 percent state ownership, was brought under the umbrella of the National Bank of Ethiopia.
Then it was reestablished by proclamation No. 158 of 1979 as a public finance agency
possessing judicial personality and named Agricultural and Industrial Development Bank
(AIDB). It was entrusted with the financing of the economic development of the agricultural,
industrial and other sectors of the national economy extending credits of medium and long-term
nature as well as short-term agricultural production loans.The financial sector that the socialist
oriented government left behind constituted only 3 banks and each enjoying monopoly in its
respective market. The following was the structure of the sector at the end of the era.

 The National Bank of Ethiopia (NBE)

 The Commercial Bank of Ethiopia (CBE)

 Agricultural and Industrial Development Bank (AIDB)

International Banking Service Process (IBSP) has been providing efficiently and
effectively the following International Banking Services for its customer who has a
credit relation with the Bank.

1. Import Transactions

Advance Payment

 Under this method, the seller receives payment from the buyer prior to
shipment or rendering the service. This mode of payment is appropriate for
imports of small items for values not exceeding USD 5,000.00 or its
equivalent in other foreign currencies. If the advance payment is more
than USD 5,000 an advance payment bank guarantee for the equivalent
amount should be presented.
 Required Documents: Performa Invoice, License, Insurance
certificate./policy, undertaking letter for the entry of goods, beneficiary's
Bank and A/C details and TIN certificate (additional documents may be
requested as and when situation demand).
Letter of Credit (L/C) /Documentary Credit

 A Letter of Credit (LC) is a conditional but irrevocable

undertaking issued by DBE to the exporter at the request of the importer
to effect payment up to a stated amount within a stated time period
against presentation of compliant documents. The Letter of Credit is
governed by the ICC rules defined in Uniform Customs Practice (UCP) 600,
NBE Directives and the Bank’s Policies and Procedures
 Required Documents: Performa invoice, Insurance certificate/policy,
License, L/C application form and TIN certificate (additional documents
may be requested as and when situations demand).

Cash Against Document (CAD) /Documentary Collection

 When an importer concludes a contract with a seller indicating method of

payment as documentary collection/CAD, prepare and submit its purchase
order to DBE for approval before shipment of goods. After the Bank
approves the purchase order ,the customer instructs the seller to ship the
goods and sends the documents via the exporter bank
 Required Document: Purchase order, Performa invoice, insurance. /policy,
License & TIN Certificate (additional documents may be requested as and
when situations demand).

(Note: For all import & export transactions, import/export permit duly filled, signed
and stamped is mandatory with NBE). The Bank doesn't provide foreign trade
services for Customers under NBE's delinquency list until they clear their
commitments or bring waiver letter from NBE.

2. Export Transactions

Advance Payment
  This is the most basic / preferred payment methods for goods. The supplier
receives cash in advance from the buyer before goods are shipped.
 Required Documents: Advance payment receipt (Incoming Telegraphic
Transfer) advice or customs declaration along with bank advice for the
sale of the Cash Notes to the Bank. (If deposited in Foreign Currency Cash
Notes), commercial invoice, sales contract, License & TIN certificate.

Consignment

 The consignment sales are applicable to the perishable items such as

fruits, cut flowers, meat, live animals, molasses and others in accordance
to the list provided by NBE,
 Required Documents: Commercial Invoice, sales contract, License, TIN
certificate & undertaking letter to repatriate the proceeds timely
(additional documents may be requested as and when situations demand)

Letter of Credit (L/C)

 An export letter of credit is an instrument issued by a foreign bank on

behalf of its importing customer favoring an exporter who is customer of
DBE.
 Required Documents: Authenticated L/C (SWIFT MT 700), Commercial
Invoice, Sales contract, License and TIN certificate (additional documents
may be requested as and when situations demand).

Cash Against Document (CAD)

 Under this mode of payment customers shipped the agreed up on goods to

the buyer and present shipping documents along with covering letter to
the bank for collection of payment
 Required Document: Commercial Invoice, Sales contract, License,
undertaking letter and TIN certificate (additional documents may be
requested as and when situations demand).

3. Foreign Exchange Service

Purchase and Sales of Foreign Currency (F/CY) Cash Notes

 Forex bureau of the Bank buy FCY Cash Notes at the prevailing exchange
rate.
 Forex bureau of the Bank also sell FCY Cash Notes for Holiday travel
expenses, Business travel allowance, medical expense, Educational
expenses and General transfers as per NBE’s Directives and the Bank’s
Policies and Procedures.

4. Foreign Exchange Remittances

Incoming Transfers

IBSP provides incoming transfer services to customer through its correspondent

banking via SWIFT

Outgoing Transfers

 IBSP also provides foreign currency transfers to foreign beneficiaries on

behalf of local customers against foreign exchange permit approved by the
Bank via SWIFT

5. Foreign Currency Account

Non-Resident Foreign Currency Accounts (NR-FCY)

IBSP opens and maintains accounts denominated in foreign currency that provides
the Account holders the privilege to instruct transfer of funds abroad without foreign
exchange permit approval or make local payments in Birr.

Retention Accounts

IBSP opens and maintains foreign currency accounts for exporters and frequent
recipients of foreign exchange remittance to enable retain all /portion of their export
earnings and inward remittances as per th